Ira M. Millstein, Senior Partner, Weil, Gotshal & Manges LLP, delivered the following address on September 11, 2013, at the 11th Annual Directors’ Institute on Corporate Governance at Columbia Law School’s Ira M. Millstein Center for Global Markets and Corporate Ownership in New York City.
Growth, innovation, and job creation should be front and center in government policy planning, according to the recent G20 Labour and Employment Ministers’ Declaration signed this past July.
Respected scholars demonstrate that, unfortunately, the current capital market works in the opposite direction. Patrick Bolton (Columbia University) and Frederic Samama (SWF Research and Amundi) point out that CEOs “ . . . remain unduly concerned about quarterly performance” and " . . . as a result continue to boost short-term earnings at the expense of long-range value maximization.” This focus on short-term results means “ . . . missed investment opportunities, more timid strategic planning, and less innovation.” The prime motivator of this corporate short-term focus is “ . . . widely believed to be the institutional investor community . . . ” – mutual funds and pension funds, either because they are passive investors, or because their managers are incentivized to the short term.[1]
Corporate boards confront from the capital markets what has become a rigid “system” of “one-size-fits-all” corporate governance, matched by those investors who embrace or countenance short-term agendas and strategies. Both are abetted by proxy advisor regimes which have outsized significance. This system needs to be changed, and can be. I believe the corporate community can only benefit from change in the whole system. Move the goal posts for both boards and investors to corporate governance and investment strategies which focus on growth and innovation for the corporation as a whole. It’s a win-win for both, and the economy as a whole.
We should try to modify the strategy of investors, many of whom press for short-term gains (quarterlies) rather than invest in the long-term goals of growth, innovation and jobs, all good for their beneficiaries, and for their corporate investees. I’ll talk in a minute about how investors might change to eliminate the short-term focus.
But before tackling the investors, I assert that boards have the flexibility to create incentives for corporate long-term growth and innovation. These basics are embraced by the American Law Institute in its Principles of Corporate Governance, §§ 2.01 and 3.01. The editors who used the term “enhancing corporate profit and shareholder gain” clearly noted that it doesn’t mean profit and gain in the short run. They said “ . . . indeed, the contrary is true: long-run profitability and shareholder gain are at the core of the economic activity. And satisfying . . . the groups with whom the corporation has a legitimate concern, such as employees, customers, suppliers, and members of [relevant] communities” is key. Their expectations are important to success in the long run. The board of directors has the duty to manage the corporation, through appropriate delegation, to achieve this long-range focus.
Taking this further requires a recognition that the capital market faced by directors is a veritable “zoo” of intermediaries such as hedge funds, pension funds, mutual funds, and others, of infinite variety. Can the board balance all the agendas, and satisfy them all? Obviously not. Yet, the board has to devise a strategy of growth and innovation if the corporation is to succeed. This means the board may have to choose what, in their judgment, is in the best interest of the corporation as a whole. Former Dean Clark of Harvard, and developing case law, say the board, in exercising its fiduciary duties, can choose what is best for the corporation as a whole.
In short then, the board can choose a strategy for growth and innovation without necessarily pleasing everyone in the zoo. Properly communicated and executed long-term strategies to win over the support of the long term will permit the board to possibly disadvantage those who embrace the short term.
And there are ways boards can help implement this strategy through incentivizing its managers, and, for example, rewarding its shareholders, through loyalty shares, and other innovations. But all of this is for another time; we don’t have time to discuss all the board’s flexibility to implement long-term strategies and balancing shareholder agendas.
I assert it is time for the private sector – corporate boards – to innovate, grow, and provide jobs, rather than hoarding cash and responding to short-term pressures. Boards can, in fact, meet the now goal posts. Major long-term shareholders, such as state pension funds, can be the impetus for supporting durable, innovative corporations.
Let’s turn quickly to these shareholders . . .
History tells us that the new concentration of shareholdings provides an opportunity to support corporations which deserve support.
In the last century, direct or indirect individual shareholdings in public corporations have increased dramatically. In 1952, about 6 percent of U.S. adults had direct or indirect shareholdings. In 1985, the figure was 28 percent; by 2002, it was 42 percent or 84 million individuals.[2] Today, that percentage stands at 52 percent (which is actually lower than the 2007 record high of 65 percent).[3]
Indeed, the beauty, but also the peril, of the evolutionary path of public corporations in the United States since the last century is that they increasingly represent the investment of a wider segment of the population, but whose investments are now more concentrated in pension funds and mutuals, who are not powerless to act, as were the mom-and-pop variety.
We – the beneficiaries – or pensioners – or retail investors – used to put our money into savings with well-regulated banks or other institutions that lent to the banks. The banks’ well-regulated money was in turn invested in conservative mortgages and industrial and business loans with significant bank capitalization requirements. Alternatively, we could invest directly in corporate stocks, for which the average holding period in the 1960s was eight years.[4] (Though the exact time frame is somewhat debated, today’s holding period is estimated to be seven months[5] by some, or even as short as five days by others.)
The costs of investing were marginal and took the form of reasonable transaction costs, and in return we received dividends or interest. Direct or indirect individual shareholdings in public companies (stocks and bonds) were pretty safe – public companies are increasingly regulated to protect shareholders.
Our money was going more or less directly to the producers of goods and services, our “savings” were being used to promote economic growth and job creation. Compensation of the bank and corporate CEOs and senior management was a reasonable multiple of rank-and-file employee compensation.
But, the mom-and-pop variety of shareholders was relatively powerless to impact corporate governance.
However, let’s remember that the capital market back then, as it does today, began with, and depends on “our” money. It doesn’t print money; it uses “other people’s money.”
Then, the whole system started to separate from you and me – the beneficiaries. Individuals used to save for retirement or to send their children to college by holding stocks in GEs or GMs directly – i.e. the “forced capitalists” as dubbed by Delaware Chancery judge Leo Strine. Today, mom and pop increasingly invest through financial intermediaries and directly or indirectly, through some very risky new financially engineered instruments. In 1980, institutional investors held approximately 37 percent of the equity markets. Today, for example, institutional investors own more than 70 percent of the largest 1,000 companies in the U.S.[6]
We must look to these institutions to change the system, and that’s a challenge.
While these institutions presumably have fiduciary duties owing to their beneficiaries, over time they became businesses with their own agendas and their own profit-seeking motives: pension funds had to increase earnings to avoid calling on their respective states for shortfalls; mutual funds became more interested in amassing assets and investors to generate greater fees; commercial banks stretched their portfolios into hedge funds and the like; and traditional intermediaries turned to alternative investments to make even greater profits.
From a governance standpoint, ownership patterns of public corporations changed, and fast. The owners of today’s corporations are not just individuals and traditional institutional shareholders such as pension funds and mutual funds, but, as some of you heard me call them, a veritable “zoo” of owners. Together with this new “zoo” came a blizzard of new high-risk and largely unregulated financial instruments. This perfect storm – of shifting ownership patterns, high risk-taking, new and unfamiliar financial instruments, and poor oversight – caused the recent financial crisis.
And, needless to say, all of these activities had questionable benefits to the ultimate beneficiaries – you and me – or to the promotion of broadly shared economic growth, innovation, and long-term job creation.
John Bogle, founder of the Vanguard Group, clearly described, in a commencement address entitled “Enough” in 2007, the transformation of our economy to one dominated by the financial sector:
When we add up all those hedge fund fees, all those mutual fund management fees and operating expenses; all those commissions to brokerage firms and fees to financial advisors; investment banking and legal fees for all those mergers and IPOs; and the enormous marketing and advertising expenses entailed in the distribution of financial products, we’re talking about some $500 billion dollars per year. That sum, extracted from whatever returns the stock and bond markets are generous enough to deliver to investors, is surely enough, if you will, to seriously undermine the odds in favor of success for our citizens who are accumulating savings for retirement.[7]
If you really think about those statements, it is clear that today our money is no longer being funneled only to industries that produce goods and services. Just look at the growth of the financial sector itself as a share of the S&P 500 earnings. It was just over 5 percent in 1980. By 2007, it accounted for 27 percent. Today, financial stocks are the second-biggest sector in the S&P 500 and are once again poised to overtake technology as the biggest industry (technology stands at 17.6 percent of the index, while finance makes up 16.8 percent).[8]
These numbers clearly illustrate this diversion of substantial capital from durable companies that produce goods and are capable of creating broadly shared economic growth. Money is instead diverted to the industry that was created to facilitate the flow of money – rather than to those industries that would create economic growth – the sectors that create jobs and real economic growth. Our money is being used to create both real and paper profits for the intermediaries. And this obsession with money, with little account for risk, is what must be confronted.
The underlying theme, then, is where to start “resetting” the goal of the capital market to support corporate growth and innovation. We have the reset goal: facilitate the flow of capital in a way that creates jobs in those industries which together will productively and efficiently employ the most Americans and ensure long-term economic growth. To do so, requires convincing long-term shareholders that it is in their respective interests to wake up to the need.
I think we must pick out of the zoo those investors who might embrace the long term most readily.
At the beginning of this speech, I stated that “major long-term shareholders, such as state pension funds, can be the impetus and support for supporting durable, innovative corporations and creating jobs.” Why is it in the interest of pension funds and institutional shareholders to take on the responsibility of prompting the economy away from short-termism? Very simply: when there are fewer jobs, greater economic disparities, and lower growth, there is also a decrease in taxes and savings and there are fewer or weaker funders (state, private or whatever). Their responsibility to their beneficiaries is imperiled. Economic stagnation is not in the long-term interest of institutional investors and is counterintuitive to their fiduciary responsibility.
I also assert that it is the pension funds that should lead the charge of this shareholder effort.
Just look quickly at the other intermediaries in the investment chain. There is, as I have called it, a “zoo.” At least one of everything! Mutuals (of infinite variety), hedge funds, banks, insurance companies, advisors (good, bad, indifferent), and on and on. Every one of them, however, serves more than one master, let alone personal gain.
At Columbia Law School, David Nierenberg and I co-chair a Center dedicated to describe in some detail the vast world of intermediaries. What are they? What incentivizes them? What do they perceive as their fiduciary duties to multiple masters? And more. Regulations may one day define and control their responsibilities a bit better, but given the embedded state of the capital markets, will never eliminate many of them as also “shareholders.” Which of them would act on the proposal we are here making? Decide for yourselves, but I doubt many, if any. Personal gain and multiple masters will cloud their vision and make murky their fiduciary duties.
That is why I pick pension funds as potential leaders of an important shareholder role: with clear responsibilities to their beneficiaries to encourage and promote innovation, growth and job creation.
What do I suggest as an action agenda, assuming you they some wisdom in why we see it necessary and desirable?
First, in the area of corporate governance, and second, in asset allocation.
To begin with, they should adopt a stated corporate governance policy based on growth and innovation. Make it simple, don’t overpromise, just state in a few paragraphs what it is, and how you will attempt to implement it. Make it public. Be thought leaders using their significant voice.
Then, put no, or at least less, emphasis on rote voting for so-called “best practices”, increasingly becoming more finite at the urging of proxy advisors and some academics. Think much more, to the extent they are equipped to do so (and if not so equipped, become so), about individual companies which are not performing well by any measure you choose (no one can cover with analysis the entire corporate community). Communicate directly with them; their boards where warranted. Note that “communication” is now “best practice” amongst most observers. Express their strong views on innovation, growth and job creation and their willingness to support corporations if they demonstrate credibility for longer range planning. Follow-up and “exit”, whenever possible where responses are inadequate; and as to indexes, urge a corporation’s exclusion, if there is no adequate response.
Public pension funds should consider more carefully what alternatives they are funding. Are they funding alternatives which in turn promote or invest in long term growth? If so, fine. If that's not the agenda, they might reconsider their funding policies
Here are a few “hot button” issues currently on the proxy advisor lists, for which some analysis might eliminate, or at least moderate, rote voting.
My favorite is splitting the chair/CEO role. (There are other issues such as, for example, staggered boards, compensation, unequal shareholder rights, political contributions, options and access – a few of which I will deal with later.) Although, splitting should be the default position, it can be more nuanced. In the recent Jamie Dimon “dust up,” my blog suggested that the resolution to split was wrong timing. The split should rarely be used to unseat an incumbent; more appropriate at succession. Mr. Dimon’s track record did not warrant “stripping” at that point. The situation was more complex.
As to staggered boards, and unequal shareholder voting rights: the default rule might be annual elections and equal rights. But again, the situation can be more nuanced, but not for absolute universal mandates.
Before voting on such issues, they should see them through the lens of innovation; growth and job action, as we are suggesting. If a company is performing well by their measure, why shake it up with a “best practice” mandate if its board and management think the practice is necessary? Defer to good management – it is not a “sin.” What might be important to management? Continuity of a board, for example. Take a start-up, or dominant investor. In either case, the start-up might not start, or the investment made, if there was a chance of a quick board turnover, at least for some period of time. When these issues come up in a proxy proposal, study the company’s response. If it is lawyerly double talk, they might ignore it; on the other hand, if it is rational business talk, they might think twice about it. The point is “not rote.” Continuity may well be needed to support innovation and growth, if seen through that lens.
As to compensation and options, here the lens becomes even more important. Are they structured to promote innovation and growth? If so, support the disclosed plan. On the other hand, if they appear to be following the herd, or structured for self-enriching and entrenching management, oppose. This requires nuanced knowledge. Note that current research seems to demonstrate that the desire of many companies not to incur the disapproval of proxy advisors has led to a growing standardization of compensation measures! Hardly a desirable outcome.
Finally, a word about the increasingly finite definitions of “independence” in board membership. More boards are rethinking their profiles. Do literal headings of “independence” prohibit potential board members who might know something about the corporation’s business? Consider persons who might more intelligently question management about strategies and tactics because they are familiar with the business, and thereby lessen the board’s complete reliance on management for information about the marketplace for the corporation’s goods and services. Thought should be given by funds as to how to properly populate boards within, or without, definitions of “independence.” Communication between them and a board can be immensely helpful to its thinking – especially with companies they are urging to innovate and grow. Again, however, they can only be selective, communicating with boards of companies that are important, but not meeting your standards of performance. They cannot cover the waterfront, but the fact that they are doing something will be an important message to the rest of the corporate world and its shareholders.
Just a word about asset allocations. Some funds are doing well enough with investment allocations. The question might well be “if it ain’t broke, why fix it?” They could dismiss allocation change on this ground.
I urge them not to do this. They can do better. I believe that if they look at investment strategy and allocations, through the lens of improving the corporate sector’s innovation, growth and job creation activities, they might well do better. The corporate sector will respond to respected long-term shareholders if this becomes a more universal mantra.
To do more focused investment allocations requires greater expertise than most funds now have, and that requires greater compensation to managers, a touchy subject for the public funds. But it’s worth it, as Ontario Teachers and a few pioneers have demonstrated.
[1] Bolton and Samama. “Loyalty Shares: Rewarding Long-Term Investors.” Journal of Applied Corporate Finance, Vol. 25, No. 3 (2013).
[2] Ira Millstein and George Vojta. "Financial Disaster Recovery: A Private-Sector Agenda for Risk Management." Directorship. Dec 2008 / Jan 2009.
[3] Lydia Saad. "U.S. Stock Ownership Stays at Record Low." GALLUP Economy. May 8, 2013 http://www.gallup.com/poll/162353/stock-ownership-stays-record-low.aspx
[4] http://www.businessinsider.com/stock-investor-holding-period-2012-8#ixzz...
[5] http://www.ritholtz.com/blog/2010/10/average-stock-holding-period-11-sec...
[6] Ben W. Heineman, Jr. and Stephen Davis. "Are Institutional Investors Part of the Problem or Part of the Solution? Key Descriptive and Prescriptive Questions About Shareholders’ Role in U.S. Public Equity Markets." Millstein Center. October 2011.
[7] John C. Bogle, founder, The Vanguard Group. “Enough.” Commencement Address to MBA Graduates of the McDonough School of Business, May 18, 2007.
[8] Mark Gongloff. "Financial Stocks Are On Their Way To Being The Biggest Sector In The S&P 500 Again." The Huffington Post. July 29, 2013 http://www.huffingtonpost.com/2013/07/29/financial-stocks-sp-500_n_3670570.html
Published July 3, 2014.
